2 Tax Rules That Could Cut Profits When You Rent Your House
Written by
John Csiszar
Edited by
Levi Leidy
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One of the biggest tax benefits that the Internal Revenue Service (IRS) provides homeowners is the exclusion of capital gains on the sale of a primary residence. While this exemption is limited to $250,000 in gains for a single person, and $500,000 for a married couple filing taxes jointly, for many homeowners, it allows for the tax-free sale of a home, even one with significant gains.
But if you choose to rent out your property to generate some extra income, build equity and have someone else pay your mortgage, you might be in for a nasty surprise in terms of taxation. Although you should definitely consult with a certified public accountant (CPA) about this tricky area of tax law, here are the basic rules you should be aware of before you decide to go down this road.
The Double-Edged Sword of Depreciation Recapture
For rental property owners, depreciation is something of a magical tax trick. When you rent a property, the IRS allows you to deduct the cost of the actual building, not including the land, over 27 1/2 years. This depreciation can be used as an expense against your rental income. Potentially, this could result in significant tax savings.
Imagine, for example, that you own a rental property that has a structure-only value of $275,000. Every year, you can deduct $10,000 ($275,000 divided by the 27 1/2-year allowable period) in depreciation expense against your rental income. So, if you were to rent out your property for $10,000 per year, all of that income would be shielded from taxation.
The trick comes when you actually sell your rental property. At that point, the IRS “recaptures” all of the depreciation you were entitled to — whether you actually deducted it or not. This recaptured depreciation is taxed at a flat rate of 25%. So, in this scenario, if you rented your property out for 10 years and claimed $100,000 in depreciation expenses, you’d owe $25,000 in recapture tax upon the sale of your property. This is one way that turning your personal home into a rental property can clip some of your profits when you sell it.
The Potential Loss of Your Capital Gains Exclusion
The big problem with turning your personal property into a rental property is that you might completely lose your capital gains tax exclusion.
According to the IRS, you must live in your property for at least two of the prior five years before selling in order for it to qualify as your personal residence and be eligible for the capital gains exclusion. But if you turn your property into a rental unit and don’t qualify for this “two in five” exclusion, the entire profit from selling your home becomes subject to capital gains tax.
An erroneously held belief by many homeowners is that you can restore the full exclusion if you move back into your property for at least two years after renting it out. While the IRS allows you to exclude your capital gains for the periods in which you resided in your property, the time when you rented it out is considered “non-qualified” and subject to capital gains taxation.
For example, if you live in your home for five years, rent it out for three, then move back in for two years, only 70% of your gain would be subject to the exclusion. The three years you rented it out, being “non-qualified,” would be subject to capital gains taxation. In this scenario, if you generated a $300,000 capital gain, $210,000 would be eligible for exemption, but you’d owe capital gains tax on the remaining $90,000.
This is certainly an improvement over not moving back in and having the entire $300,000 capital gain subject to taxation. But either way, using your property as a rental could cut into your profits when you sell it.
The Bottom Line
Tax law is complicated, particularly when it comes to scenarios like rental versus personal use of property. The simple scenarios outlined here overlook numerous other factors that affect the financial viability of the situation, such as the mathematical benefits of the depreciation deduction. In fact, in many scenarios, renting out your property still provides more financial pros than cons, even if you have to pay depreciation recapture and some capital gains taxes.
If you’re considering this strategy, be sure to talk it through with a CPA so that you completely understand all of the tax ramifications, both good and bad.
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